Thinking in Real (Options) Time

How companies are maximizing the power of real options thinking without getting bogged down in complexity.

Is real options valuation a powerful
business tool, or is it just too complex to be practical in corporate environments? A growing number of companies are rethinking real options, harnessing the model's power without immersing themselves in complicated mathematics. A study of 39 companies conducted by Alex Triantis, associate professor of finance at the University of Maryland's Robert H. Smith School of Business in College Park, Md., found that most businesses using real options valuation use it in three key ways: as a mode of thinking, as an analytical tool and as an organizational process. "If I were a CFO, I would use real options as a way of thinking" but not as a financial tool because of the model's complexity, says Martha Amram, co-
author of "Real Options: Managing Strategic Investment in an Uncertain World" (Harvard Business School Press, 1999) and interim CEO of Cupertino, Calif.-based Vocomo Software Corp., a provider of voice applications.

The real options model applies financial options theory to the identification of options for nonfinancial assets -- that is, to the valuation of certain actions a company has the right but not the obligation to take at some point in the future. "Many companies see this as a new way of thinking and are using it to find different ways to structure projects," says Triantis.

The oil, energy and pharmaceutical industries have long used the real options framework to assign value to nonfinancial assets like R&D projects and oil leases. "Real options prices the value of an opportunity," says Brice Hill, controller in the server division of Intel Corp. in Hillsboro, Ore. And companies can use a real options valuation to determine how much they are willing to spend to create an option on a particular opportunity. "It used to be that any level of investment was appropriate to create a strategic option," says Hill. "But now if an option has a specific value -- say, $50 million -- then a company might be willing to spend up to $50 million to create that option."

For years, Intel was frustrated because it had trouble tying strategic decisions to hard financial analysis. "We found that real options allowed us to more properly value strategic decisions using appropriate criteria," says Hill. "It also allowed finance to provide analyses for the businesses that were more strategic in nature."

Real options valuation grounds strategic thinking and decision-making in concrete financial analysis. "When companies make strategic investments, they tend to do so with a thumbs up or thumbs down from the CEO and no financial analysis to the decision," says John McCormack, senior vice president and head of the energy practice at Stern Stewart & Co., a management consultancy in New York City. "But when you have strategic investments that require choices in the future," real options can guide those decisions. The model also enables an organization to recalculate the value of a project or investment as it progresses and to understand what must happen before the project or investment can move successfully into the next stage of development. "Real options can be a good first step in identifying the forces that create value," says Amram.

But real options thinking is not appropriate for every investment because putting the model to work takes time, effort and expertise. "Real options is best suited for major investments with results far in the future and a lot of managerial choices in between," says McCormack. "In those situations, real options analysis is not only appropriate, [but] I think it is necessary."

Some organizations have found that real options valuation in its purest form is not relevant to their operations. Genentech Inc., a San Francisco-based biotech company, has decided that the arbitrage principle used in real options thinking doesn't apply to many of its business investments. "Because we find it difficult to effectively use all the features of real options, the basic framework of real options is just one of the techniques used in our company," says Rupert D'Souza, Genentech's director of financial planning and strategic analysis. "We don't use it in everything that we do, but it is the standard methodology in the valuation of all our R&D investments."

In the Beginning...

So, where do companies start if they want to use real options? Texaco Inc. began with a pilot project that applied the model's analysis to one asset, a substantial, long-held lease in a developing country. The company was trying to decide whether to maintain the lease and commercialize it or exit it. Relying on real options thinking, Texaco's project team valued all the options available to the company, factoring in the risks and uncertainties. In doing so, the team gained a robust understanding of the lease's risks and the cost of those risks, and determined that the asset's market value was substantially lower than had previously been assumed.

Once the analysis was complete, the company had a much clearer picture of the lease's overall value, and it used this knowledge to develop a dynamic asset management strategy. The choice be-tween maintaining and monetizing the lease was guided by a clear roadmap built around critical uncertainties and decision milestones. Texaco's first exercise in real options valuation yielded insights that now assist in the management of other company assets, inform the timing of development decisions and encourage a more rigorous strategic framing.

"The key is to focus on the options thinking rather than the options mathematics," says Soussan Faiz, former manager of global valuation services for Texaco in White Plains, N.Y. "Just going through the rigor of strategic framing combines a lot of management tools, processes and techniques under the real options umbrella."
Texaco's project team began with more conventional valuation tools within the real options framework to ensure management's gradual buy-in and comfort with the entire process.

Since the initial pilot project, Texaco (now part of ChevronTexaco) has used real options to evaluate venture capital opportunities, mature projects, new businesses and a substantial international portfolio, says Faiz. Overall, she estimates, real options valuation has helped Texaco unleash an additional $3.6 billion in value by helping executives change the way they think about specific assets, make better decisions and align strategy with the market.